CHAPTER 4 Time Value of Money In this chapter. we wish to explore the value of money over time. Any investment decision involves paying an amount on the spot to acquire an asset in hope of achieving financial gain at a future time. Companies, for instance, invest in machines and equipment (tangible assets) in hopes of receiving more money from the use of these assets. Investment could also be made in other intangible assets such as patents or trademarks, Again, the whole idea is to invest an amount today in hopes of achieving some return or gain in the future. Individuals invest in financial assets as well. The decision to invest your money in financial instruments, e.g., bonds and stocks. in hope of achieving some return in the future is a key in point. In short. whether it is a company or an investor, the entire financial plan i based on time: when the time clement is not present, the future doesn't exist, and consequently, investors have no motive to buy assets in the first, place. The objective of this chapter is to familiarize the reader with the role played by time in financial transactions or financial contracts. In particular, we discuss how to calculate the future value to which current money invest will grow, the present value of a future payment, and to how compute the interest rate implied by the present value or the future value. 1, Future Values Consider this simple financial contract. Suppose you seek to invest $100 in a bank account. The bank is currently paying an interest rate of 10% per year on deposits. We wish to compute the value of this $100, that was deposited today, at the end of the year. Let FV denote the future value, PV denote the present value, r be the interest rate, and J be the interest payment. In this example, PV = 100, r = 0.1, and FV is what we wish to find. The interest payment is simply the interest rate times the amount invested; that is, (4.1) I= rxPVv 0.1 x 100 = $10. Thus, by the end of the year, you should have $100 + $10 in your bank account; that is, the future value is simply the present value plus the interest 79 Scanned with CamScannerso 4. TIME VALUE OF MONEY payment: (4.2) FV=PV4I. Substituting the definition of J in equation (4.1) back in (4.2) yields the future value formula for an amount growing at a rate r for one year: FV4¢ the end of year 1 = PV (1 +r). Suppose you are at the end of year 1. If you made the decision to leave your money in the bank for a second year, the current balance, which $no now, will grow for another year at a rate r = 10%. The future value in this case will be F Vat the end of year 2 110 + (0.1 x 110) 110(1 + 0.1) = 100(1 +0.1)(1.01) = 100(1+0.1)? = 121 Thus, FYVae the ond of year 2 = PV (147° In the same way, we can easily see that the future value of a PV after n years growing at an annual rate r is calculated by the following formula (4.3) FV =PV(1+r)". Calculating the future value from the future value equation in (4.3) is easy using almost any calculator. If you don’t have a calculator, you can use a ta- ble of future values. This table shows the future value of a $1 investment for various interest rates and investment periods. The future value of a $1 in- vestment at r percent per period for n periods is known as the future value interest factor (FVIF) and is usually denoted as FVIF(r,n). Thus, (4.4) FVIF(r,n) = (14r)". Future value tables are tedious and they usually show future values for only a limited set of interest rates and time periods. The power key on your calculator is faster and easier. Alternatively, you can use financial calculator or spreadsheets. Notice that, in the previous example, y ‘our interest income in the first year is Fin year 1 = 0.1 x 100 = $10 and in the second year I in year 2 = .1 x 110 = $11. Nour income at the end of the second year is $121 ($100-+$10-+$11) is higher because your Fg inins interest on interest. This is called compounding or compound interest. If, on the other hand, the bank calculated you" Scanned with CamScanner2. PRESENT VALUES st interest based on your original investment, you would be paid simple interest. With simple interest, your balance at the end of the year would be $120 (100 +2 x $10). EXAMPLE 23. Consider the following investment opportunity: Lend a bor- rower today $100 and receive, after two years, $120. What will be your rate of return on investment if you accept this deal? In this example, we have an amount today PV = 100 and a future amount FV = 120 inn = 2 years. The interest rate on this investment opportunity, r, is the rate of return that you will make as an investor. Notice how r here has a different meaning: it is the rate of return on your money and not the bank rate, Now, we wish to find that rate. Using the FV formula, we know that FV =PV(1+r)", ‘where PV = 100, FV = 120, n = 2, and r is the only unknoum in the formula. Now, we solve for r as follows: FV PV(1+r)" 120 = 100(1 +r)? Tut) hye ).095( or 9.5%). Thus, your rate of return if you choose this investment opportunity will be 9.5%. Before we turn our attention to present values, it is worth noting that, in the context of computing the FV of a PV, the interest rate r in equation (4.3) is thought of as a growth rate. It is the rate by which the current amount grows over time. As we will discuss in the next subsection, r has a different meaning when computing the PV of a FV; it is the discount rate. 2. Present Values Future value is calculated by multiplying the present value by one plus the interest rate. Then, to compute the present value, we simply divide the future value by one plus the interest rate. This is easy to see from the simple manipulation of equation (4.3): EvVafter n periods +r)" (4.5) Pv Scanned with CamScannera 4. TIME VALUE OF MONEY The present value is the value today of a future cash flow. The interest rate r in the present value formula in equation (4.5) is known as the discount rate and the present value is sometimes called the discounted value of the future payment. EXAMPLE 24. Suppose you are planning to buy a new computer worth $4000 after 1 year. If the interest rate on deposits at the bank is 6%, how much money should you set aside today in order to pay for your purchase in one year? Here FV = $4000, n = 1, r = 0.06. Then, the present value is easily obtained by direct substitution in equation (4.5) as follows: 4000 Fe Vay 0.06)? = $3773.6. Notice that investing $3773.6 at 6% yields $4000 in one year. Thus, $3773.6 is the discounted value of a $4000 future payment. It is often useful to express the present value formula in equation (4.5) as follows bt PFe= (4.6) VaFV xa The term 1/(1+ 7)” is called the discount factor or the preset value interest factor (PVIF). It measures the present value of $1 to be received in n years from today at a discount rate r percent. 1 4.7) PVIF(r,n) = ——,. (47) (3) = Gay The simplest way to find the PVIF is to use the calculator or spreadsheets. Some financial managers, however, find it convenient to use tables of dis count factors. EXAMPLE 25. | Kangaroo Autos is offering free credit on a $10,000 car. You pay $4,000 down and then the balance at the end of 2 years. Shark Motors next door does not offer free credit but will give you $500 off the list price. If the interest rate is 10 percent, which company is offering a better deal? In this example, we have two different pattern of cash payment. In such a case, we should compute the present value of payments in each alternative. Using the time line below, we can find the present value of the payments to Kangaroo by adding the 4,000 paid on the spot to the present value of the Adapted from Brealey et al (2006). Scanned with CamScanner2. PRESENT VALUES 33 $6,000 owed in 2 years. 4000 6000 T aes fae | 0 1 2 000 eo, ee He T4017 PV=atb Notice that the $6,000 payment is due at the end of year 2. To come up with 6,000 in two years at a rate of 10%, you will need 6000/(1 + 0.1)? today. Thus, the PV of payments to Kangaroo is 6000 (+01)? The present value of payments to Shark is PV snark = 10000 — 500 = $9500. Thus, Kangaroo is offering a better deal. The point of this example is to never compare cash flows occurring at different times without discounting them to a common date. PViangaroo = 4000 + = $8958.68 ‘The PV formula in (4.3) or the FV formula in (4.5) can be used to find the interest rate or the investment period. The following examples illustrate these cases. EXAMPLE 26. Suppose your friend proposed to borrow from you a $1,000 today and promised to pay you back $1,200 in two years. If the interest rate on bank deposits is 9%, would you rather invest your money in the bank or accept your friend's proposal? In this example, the opportunity cost of your money is 99%. You need to calculate the rate of return, i.e., the interest rate, that you would achieve if you decided to accept your friend's proposal. Using the PV formula, we have 1200 This is one equation in one unknown, r. You simply need to solve for the interest rate as follows: 1000 = 2, 1200 = (1200)! Gtr? = gg > A+ = (ig = v= (i) 0.095. Thus, you should accept your friend’s deal since the rate of return on this investment is 9.5%, which is higher than the rate that you can otherwise achieve by depositing your money in the bank. Scanned with CamScanneras 4. TIME VALUE OF MONEY EXAMPLE 27. Consider the previous example. Assume that everything is known except for n; that is, 1000 1200 (1+ 0.095)" E We can easily find n as follows: (1 +0.095)" Take the natural logarithm on both sides and remember the rule: loga" = alogz. This gives = tog (2200 nlog(1+0.095) = los ( F599 n= 108 (1588) Tog(1 + 0.095) 3. PV and FV of Multiple Cash Flows In the previous sections, we looked at problems involving one single cash flow. In this section we consider investments characterized by a stream of cash flows. In this type of problems, drawing a time line is very useful in computing the present value or the future value of the cash flows. EXAMPLE 28. Suppose you are planning to buy a computer in three years. You decided to set aside, or save, $1,000 today, $1,200 at the of year 1, and $1,400 at the end of year 2 at an interest mate of 10%. How much will you be able to spend on a computer in three years? In this ecample, we basically ‘want to find the future value of a stream of cash flows. Using the future value formula, we can simply bring all cash flows to the beginning of year 3 as follows: 1000 1200 1400 u T T 0 af eee eects rea 3 oa 1400(1.1) Sete ee 1200(1.1)? SOS se = 10000118 FV=a+bte FV = 1000(1 + 0.1)* + 1200(1 + 0.1)? + 1400(1 + 0.1) ry 29. ? Suppose that your auto dealer gives you a choice between paying 15 f00 for a new car or entering into an installment plan where you pay $8,000 down today and make payments of $4,000 in each of the “Adapted from Brealey et al (2006) Scanned with CamScanner4. PERPETUITIES AND ANNUITIES as next 2 years. Which is the better deal assuming that the interest mite you can earn on a safe investment is 8%? If you compare 15.500 and 16,000 as the total payments under the two plans, you are completely ignoring the time value of money. The right way of comparing two plans that involve different payments at different times is to discount the payments and compare the present values. The present value of the first plan is simply $15,500 today. Now, let's find the present value of the second plan. Again, we can use the time line to discount all future payments pertaining to this plan using 8% interest rate as follows: 4000 4000 + T t 1 2 ar 4000 Tra ocosye = 15+ 188.06 Thus, you are better off taking the second plan. 4. Perpetuities and Annuities ‘An annuity is a stream of cash flows that is equally spaced. A perpetuity is a stream of cash flows that never ends. For instance, a 25-year mortgage that require equal monthly payments is an annuity. A preferred share that promises the holder fixed dividends for ever is a perpetuity. Our task in this section is to evaluate these types of cash flows. 4.1. PV of Perpetuities. Sometimes governments borrow by issuing perpetuities, The government pays the investors holding these perpetuities a fixed payment for ever. Let F = $100 be the face value of the government bond. This is the amount that the investor must pay, which is also the amount that the government borrows, in order to own the bond. Suppose that the bond promises an interest rate r = 10% every period for ever. The interest payment or cash payment, denoted by I, is $10 (10% x 100); that is, the cash payment is calculated from the following formula: T=rxF. Scanned with CamScanner= 4. TIME VALUE OF MONEY This perpetuity then guarantees the investor $10 each period for ever. What is the present value of this perpetuity? 10 10 10 1 1 I 0 BREE Leet Eee ia lial Bo es wer 0 i Metis ote eet Pee te te wor eH A quick look at the time line above, one can see that the PV is simply the discounted value of the fixed payment of $10 for ever; that is, ae + 0 + (i+ 1)? ~ (1+ 0.198 How can we evaluate this progressive sum? Luckily, there is a neat and simple mathematical trick that we can use to derive a simple formula to value any perpetuity. Here is how it is done: Secret epee cepa © +r" +rP* 0 +r)3 Take J common factor and re-write equation (4.8) as follows: PV= (4.8) Pv [ 1 1 + 1 ip (+r) (+r? (+r Notice that 1 raised to any power is still 1. Thus, (4.9) fe +747 . aaa where 7 = 4 is the discount factor. Now, let denote the sum on the right-hand-side of (4.9). If we deduct 7S from 5, we simply obtain + since all the terms with exponents higher than one cancel out; that is, 8 ytPeheee = Ss PtPtee Thus, or equivalently, a tH Scanned with CamScanner4. PERPETUITIES AND ANNUITIES a Substituting 4 back in equation (4.9), we obtain the very simple formula I (4.10) PV =~ : Thus, the present value of any perpetuity is simply the fixed cash payment divided by the interest rate (or the discount rate). Sometimes a perpetuity doesn’t start to make payments for several years. You can still invoke the general present value formula for a perpetuity in (4.10) at the starting year of the perpetuity. But, then you ought to bring the PV back to year zero using the conventional discounting formula. The following example illustrates this case. EXAMPLE 30. Consider a perpetuity that pays out $1000 a year with the first payment 3 years from now. If the discount rate r = 0.1, what is the present value of this perpetuity? Again, the time line is extremely useful in this type of problems. 1000 1000 I T 0 Sole oe 2 Eee eet Het et 1000 eo es i oo ee Z| =u PVs = 102 PV = ap eee e A quick look at the time line above, one can notice that the present value formula of a perpetuity gives the discounted value of all infinite payments at the beginning of year 2; that is, 1000 OL To bring this amount back to year 0, we ought to discount it for two years. Thus, the PV of this plan is PV year 2 = = = 10,000. (140.1)? 4,2. PV of Annuities. Now, let's turn our attention to annuities. Consider an annuity that pays a fixed cash flow, CF, every year/period for n years. Let r be the discount rate. How can we compute the PV of such an annuity? We will perform the same mathematical trick as in perpetuities. The only difference is that n in our case doesn’t go for ever. Scanned with CamScannera 88 4. TIME VALUE OF MONEY That being said, we can write the PV of all future discounted cash flows as follows: CF CF CF CF | v= |“ 4+ eG - [Sort ae (+r 1 1 1 = CF stat lar Ger?" a4r* 1 tye (2 y = aes ——) tet ani (4:)+() + T+r, Ae Ne Let 7 the right-hand-side is Saye Pt Pte t7 and pant Thus, or equivalently, so-D=rr—-0 — 5-19. Substituting the definition of 7 in the sum S and simplifying yields ie (mb-1) ee (e—1) 1 Se cara ie ler eI Ter Thus, the PV of an annuity that pays CF every period for n periods is 1 1 (4.11 PV =CF x |- -——_,, (an) x orl What about the future value of an annuity? Well, there is no need to derive the future value formula from scratch. Simply recall that FV =PV(14r)" and substitute the PV formula (equation (4.11)) back in the FV formula to obtain FV =CF x b-aie (len r 1+r)" f with cash flow CF, interest rate ™ This is the future value of an annuity over n periods. Here is an example. Scanned with CamScanner4. PERPETUITIES AND ANNUITIES 89 EXAMPLE 31. A couple thinking about retirement decide to put aside $9,000 each year in a savings plan that earns 8 percent interest. How much money will they have accumulated 30 years from now? We have an annuity with CF = 3000 for n = 30 years at an interest rate r = 8%. The FV formula is simply the conventional PV formula of any annuity times (1 +7)"; that is, 1 1 = FV = OFx [:-atrl (+r) . L-* 4 30 oe las R(T + 0.08) |] a) = $339, 850. REMARK 7. The perpetuity and annuity formulas assume that the first pay- ment occurs at the end of the period. Sometimes, however, streams of cash payments start immediately. In such a case, the annuity is called an anmu- ity due. The computation is essentially the same; the only difference is that the first payment is made immediately. The distinction between an annuity due and an ordinary annuity is best made by consulting the time line. Here is an example of a three-year ordinary annuity versus a three-year annuity due: Ordinary Annuity Cr CF cr T T q 0: bess pil guemom nue od shee co 8 ao ce ae be oe KH ees hes a es c= OH PV=atbte Annuity Due CF CF CF fl T ) OC 4 F 9 cme OO PV =a+bte Notice that the annuity due in this case is simply a 2-year ordinary annuity plus an immediate payment. Thus, the present value of an ordinary annuity és calculated from the following formula: 1 1 PV annuity due = CFo + OF x i: ~ iat | Scanned with CamScanner